Energy Investing: Your Questions Answered

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The stock market has confounded the critics thus far in 2012, rallying 4.5 percent. A number of laggards from 2011 have led the way, including financial and oil services stocks. Nevertheless, many investors recall the gut-wrenching volatility of last year and remain wary of the recent rally. This skepticism is hardly a surprise: The EU sovereign-debt crisis and the health of the global economy remain a cause for concern.

Last Thursday, I hosted one of my regular Live Chat sessions with readers of The Energy Strategist. Here are my responses to a handful of common questions from subscribers.

What are the prospects for natural gas prices in North America?

At the beginning of 2011, my bearish outlook for North American natural gas prices elicited some critical emails. But as I predicted, a persistent oversupply ensured that the commodity traded for less than $5 per million British thermal units (Btu) for much of 2011.

I revised my estimates slightly in September, emphasizing that natural gas prices would likely decline even further–perhaps to new lows–late in 2011. I can see North American natural gas prices breaking below $2 per million Btus if the weather remains mild heading into the spring.

Natural gas prices may bottom this year, but investors shouldn’t expect much upside for the commodity for at least the next two years. Even with producers shifting spending from shale gas plays to oil- and liquids-rich fields, natural gas production continues to increase. Natural gas prices could rebound temporarily to between $4 and $5 per million Btus if there’s a summer heat wave or hurricane-related supply disruptions. Overall, I see no reason to be bullish on gas prices in North America.

That being said, supply and demand conditions for liquefied natural gas (LNG) remain sanguine in international markets.

The Asia-Pacific market tightened substantially in 2011, as China brought two new import terminals online. China’s monthly LNG intake increased an average of 30.7 percent through the end of August 2011, a remarkable feat after the country’s LNG demand surged 67 percent in 2010.

Meanwhile, Japan’s demand for LNG has spiked after the magnitude-9.0 earthquake permanently damaged the Fukushima Daiichi nuclear power plant and forced the government to shut down many of the country’s nuclear reactors for stress tests. As of the end of December 2011, only six of Japan’s 54 nuclear reactors were operating. Legislation requires that these reactors undergo maintenance every 13 months; unless idled capacity is brought online, the nation could find itself with a severe power shortage in May.

Accordingly, we expect Japanese demand for LNG cargos to remain robust, particularly during the summer cooling season and winter heating season, which should keep prices elevated in 2012.

European demand for natural gas will likely moderate in the coming year because of economic weakness, but elevated oil prices should continue incentivize utilities to reduce purchases of oil-indexed pipeline gas to the lowest levels allowed by contract, replacing these volumes with lower-priced LNG. Two of the biggest winners from increasing demand for LNG cargos will be Golar LNG Partners LP(NSDQ: GMLP) and Teekay LNG Partners LP(NYSE: TGG), master limited partnerships (MLP) that own fleets of LNG carriers. The LNG tanker market the sole bright spot in the shipping industry, and the day-rates earned by these vessels should climb even higher in 2012.

What’s your take on Chesapeake Energy Corp (NYSE: CHK) and its growth prospects?

Chesapeake Energy Corp is a quality firm that continues to shift its focus from natural gas to oil and natural gas liquids (NGL), both of which trade at higher prices and offer superior wellhead economics.

The company has also been at the forefront of monetizing its assets by selling noncore acreage, forming joint ventures with international oil companies and spinning off assets into MLPs and royalty trusts. The company had taken on considerable debt to amass huge swathes of acreage in emerging shale oil and gas plays; the company’s creative efforts to monetize these assets enable the firm to fund its ambitious drilling program.

In some ways, Chesapeake acts like a private equity firm, buy acreage at reasonable prices, proving its productivity and then selling it to cash-rich foreign oil firms.

I prefer Growth Portfolio holding EOG Resources(NYSE: EOG), which boasts superior exposure to oil and NGLs. I suspect much of the recent weakness in Chesapeake Energy’s stock price reflects the decline in natural gas prices.

I don’t think so. Both of these royalty trusts have significant exposure to oil and NGLs.

Oil prices remain elevated, and I’m bullish on NGL prices. Demand from petrochemical producers is strong and exports protect the market from oversupply. To clarify that point, the US doesn’t export liquefied natural gas (LNG), but it does export natural gas liquids (NGL).

Both trusts have hedges that blunt the effect of volatile commodity prices on their cash flow, while the subordinated units also cushion investors from a potential distribution cut. That is, if the trusts’ distributions fall below a minimum threshold, Chesapeake Energy Corp and SandRidge Energy (NYSE: SD) would forego a portion of their distributions to make the trusts’ unitholders whole.

It’s not against the law to hold US oil and gas trusts in an IRA. However, these securities defer much of your tax burden until you sell them; holding oil and gas trusts in a taxable account allows you take advantage of this feature.

Second, the unrelated business taxable income (UBTI) generated by these trusts could saddle you with additional filing requirements if you hold the securities in an IRA. The first $1,000 of UBTI you receive in an IRA account is exempt from taxes, but any amount in excess of this threshold would incur a penalty. The administrator of your IRA would report any UBTI to the internal revenue service.

I’ve read some wildly divergent opinions on how oil prices are determined. Is the market being manipulated by OPEC or speculators? Is demand really going to fall because of the coming Euro/global recession, or are emerging markets going to suck up any new oil production rapidly?

I’ve long contended that speculators don’t have a significant long-term impact on oil prices. Politicians and pundits often scapegoat speculators for high oil prices, a claim that’s inaccurate but plays well with the general public.

Consider the following scenarios. If speculation artificially inflated oil prices, producers would drill more aggressively to take advantage of higher prices and consumers would attempt to conserve. In other words, oil inventories would increase and consumption would decrease, exerting downward pressure on oil prices.

This scenario is pure fantasy. Aside from the Cushing hub in Oklahoma, oil inventories have declined worldwide. Although producers are spending more on exploration to boost output, it’s not working: non-OPEC production growth was disappointed last year. Oil prices are rising because the market is tight, and supply isn’t keeping pace with demand. Producers face the end of easy oil and are now forced to target more complex and expensive-to-produce fields such as those in the deepwater, the Arctic and the Canadian oil sands. Oil must hover around $100 per barrel to incentivize production from these frontier plays.

OPEC’s role in global oil markets is complex. When OPEC votes to raise output, oil prices paradoxically rally. That’s because any incremental increase in OPEC production reduces the amount of spare productive capacity. Higher production from OPEC is often bullish for oil prices.

Rising oil demand is the biggest driver of oil prices. Europe accounts for 15 percent to 16 percent of global oil demand, but the continent’s consumption has declined for years. US oil demand has also fallen generally over the past decade and will probably be flat over the next few years. Rising demand in the developing world, particularly China, will continue to drive oil demand. With oil supplies likely to remain tight in 2012, prices should remain elevated. In the short term (the next month or two), I expect West Texas Intermediate crude oil to rally to more than $105 per barrel.

Which US shale plays are the most promising?

I prefer names with exposure to the Bakken Shale in North Dakota and the Eagle Ford Shale in south Texas, a bias that reflects my bullish outlook for oil and NGL prices.

The Bakken Shale produces primarily a light, sweet crude oil that commands a premium in most markets. Well costs in the region are relatively inexpensive and produce outstanding rates of return. The Eagle Ford Shale contains substantial amounts of oil and NGLs.

I’m less excited about the Haynesville Shale and other gas plays. The Marcellus Shale is the best bet in this unloved bunch, as the field boasts some of the lowest production costs in the nation.

Uranium stocks have rallied recently. What catalyzed this move?

Two proximate causes are behind the recent strength in shares of uranium miners.

First, improved US economic data and some improvement in EU debt markets have brought the risk-on trade back in vogue. Energy-related names, including uranium producers have benefited from investors dipping their toes back into riskier equities.

Although stock prices in this industry will remain volatile, the secular growth story in nuclear power remains intact over the intermediate to long term. The Fukushima Daiichi disaster has weighed on near-term uranium demand, but China and India still plan to aggressively add nuclear power plants. Meanwhile, delayed or canceled mining projects should offset lost demand in Germany.

The uranium market is prone to sudden shifts in momentum. If demand in the spot market picks up, uranium prices could double to $100 per pound. Timing these moves is difficult, but the yellow metal will eventually have its day in the sun.

I purchased Kinder Morgan Energy Partners LP (NYSE: KMP) a few years ago and locked in a great yield. Nevertheless, the stock price has run up a great deal. Should I consider selling some of my position?

That being said, shares of Kinder Morgan Energy Partners are overbought at these levels, largely because investors are tripping over themselves to add safety-first names that pay a sustainable dividend. Investors should wait for a pullback to add to their positions.

Every investor should review his or her holdings periodically. Let’s say you bought a stock in 2008 during the financial crisis. At the time of purchase, the stock may have represented 5 percent of your portfolio. But after a couple of years of solid gains, the stock now makes up 15 percent of your portfolio. If a position has grown to the point that it throws off the balance of your portfolio, you may want to consider taking some profits off the table. Prudence dictates that no single position should be allowed to dominate your portfolio.

You also should consider your particular tax situation before deciding whether to sell a stock.

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